In the wake of the recent dive on Shanghai's Stock Exchange, which quickly impacted worldwide financial markets, Dr Milan Simic examines the potential impact of large losses from earthquakes and other natural hazards in China.

The recent fall in China's stock market - the biggest in the last ten years - created shockwaves which are still being felt across the world's major financial markets and has led to even more intense debate amongst analysts about the inter-linkages of our globalised economy. But there has still been surprisingly little discussion about the financial shockwaves which could potentially be created from natural disasters in China - a country exposed to practically every natural hazard, with earthquakes, typhoons and floods having the greatest loss potential.

The world's financial and insurance markets are now routinely stress-testing their behaviour and performance against potential losses from events such as large earthquakes around Tokyo, major hurricanes in Florida or severe storm surges in London. However few organisations are investigating the impact of a devastating earthquake around Beijing, a severe typhoon hitting the Hong Kong /Guangdong region or major flooding in Shanghai. Drawing on reviews of the Chinese insurance market and earthquake risk in China, published recently by the Benfield UCL Hazard Research Centre, along with other sources, this article examines the potential impact of losses from earthquakes and other natural hazards on the Chinese insurance and international reinsurance markets.

Major changes, rapid growth

Following the implementation of economic reforms that started in the 1980s, China's economy has undergone rapid development in recent years. Against this backdrop, the insurance market in China has also prospered. Insurance premium income growth in recent years has exceeded expectations, with total premiums increasing from $26bn in 2001 to $61bn in 2005 - an average annual growth of around 25%.

Despite impressive growth, the insurance industry in China is still a small part of the overall Chinese economy, accounting for less than 3% of GDP, compared with around 11% in Japan. Awareness of insurance remains low amongst much of the population and huge regional disparities exist, reflecting the relative wealth of major cities such as Shanghai and Beijing compared with the rural areas.

Property insurance in China is biased towards commercial rather than residential property, reflecting relatively low levels of home ownership. On top of this, natural catastrophe cover is limited, making catastrophe insurance relatively small in world terms.

Another important feature of Chinese property insurance is its geographical concentration. Most of the economic development, and therefore the majority of insured property, is concentrated in coastal regions and provinces. In addition, the top five Chinese insurance companies controlled more than 90% of the property market in 2005 (table 1).

Exposure to all natural hazards

China is exposed to practically all major natural hazards. River flooding is a regular occurrence, affecting, often with deadly consequences, large numbers of people who live along the basins of major rivers (figure 1). However, from the insurance point of view, the regions most prone to flooding are those with relatively low insurance penetration, making the current insured flood loss potential in China relatively small.

Typhoons in the West Pacific are also a frequent occurrence, with China being affected by an average of seven landfalling typhoons every year. The 2006 season was particularly active, and with ten recorded typhoons well above the average. August 2006 saw the development of the eighth typhoon of the season, the super-typhoon Saomai, which affected the Fujian and Zhejiang provinces in southeast China. Saomai made landfall with windspeeds between 200kph and 250kph, and was described by Chinese meteorologists as the strongest typhoon in the last 50 years.

Nearly two million people were affected by Saomai and the economic loss from the event has been estimated by Swiss Re Sigma at around $2.5bn. However, the insurance/reinsurance loss was a fraction of the economic loss.

Seismic hazard

Despite the frequent occurrence of floods and typhoons, it is now widely accepted within the insurance and reinsurance community that earthquakes pose the greatest loss potential in China. A report published by Benfield in October 2006 provided a review of the science of earthquake recording, seismicity and seismotectonics in China, in addition to addressing historic earthquakes, seismic hazard, vulnerability of the buildings stock and financial implications of earthquake risk in the country.

China has a unique record of historic earthquakes, at around 3,000 years arguably the longest in the world. 2006 saw both the 450th anniversary of the 1556 Shaanxi earthquake and 30th anniversary of the 1976 Tangshan earthquake. These two events are known as two of the deadliest earthquakes worldwide, causing around 830,000 and 300,000 fatalities respectively (figure 2).

Starting from historic seismicity, Chinese scientists have constructed hazard maps that are used for building and infrastructure design. These maps illustrate that the central and western parts of the country are more prone to earthquake activity. However, as discussed above, most of the current economic activity, and therefore the majority of insured properties, are currently concentrated in coastal regions in the east where the seismic hazard is relatively low. The only major exceptions to this are the areas of greater Beijing and Tianjin, where both seismic hazard and insurance take-up are relatively high.

By combining earthquake hazard and building vulnerability, Chinese scientists were able to make estimates of the financial risk in terms of regional GDPs. After carrying out similar calculations using its database of currently insured property in China, the ReMetrics Natural Hazards team has estimated that the country-wide insured losses with the return period of 250 years could be of the order of $1bn to $1.5bn. In worldwide reinsurance terms and in comparison with significantly higher recently experienced insured losses (from Atlantic hurricanes in 2004 and 2005, for example), such losses could be relatively easily absorbed by the international reinsurance market. But this situation won't last for ever. As insurance penetration grows, so too will the potential for larger insured losses.

Also, largely because of the current low insurance take-up, the equivalent economic loss from a 1-in-250 year loss could be well over one hundred times greater, of the order of $100bn to $150bn. This currently represents between 4% and 6% of China's GDP and will be accompanied by a significant impact on the country's population, industry and government. It is this wider impact that such a major catastrophe could have on global financial markets that currently presents a greater worry to the insurance and reinsurance markets than the scale of any insured losses.

- Dr Milan Simic is a member of the ReMetrics Natural Hazards team at Benfield.